Operational Risks and Your Custodian: A Perfect Match?

1 Aon Hewitt Retirement and Investment Risk. Reinsurance. Human Resources. Operational Risks and your custodian : A Perfect Match? November 2014 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. Aon Hewitt Retirement and Investment Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. Operational Risks and your custodian : A Perfect Match? 1 Introduction Institutional investors have always been concerned about risk, but with the increasing complexity of investment opportunities, the broadening of asset allocations beyond simply stocks and bonds, and the global nature of investment portfolios, monitoring all the Risks associated with an investment program has become a more significant undertaking. This paper identifies the Operational Risks that institutional investors face specifically those Risks that come with safekeeping, monitoring, and reporting on a plan s assets and discusses the implications for evaluating custodians.

2 Whether a plan utilizes separate accounts, requires consolidated reporting, or needs assistance with benefit payments, cash movement, or private asset reporting, most institutional investors rely heavily on the custodian bank to provide Operational support for the investment program. Therefore, institutional investors should evaluate a custodian s capabilities through an Operational risk lens. This paper establishes the Operational risk lens institutional investors should use when evaluating their custodian by: 1. Defining the key Operational Risks faced by institutional investors; and 2. Summarizing, for each identified risk, the capabilities, processes, and infrastructure a custodian should possess to be a Perfect match for a program that faces that risk. Role of a custodian Bank The primary role of a custodian bank is to hold in safekeeping the assets of its clients. Similar to a personal investment account, the custodian maintains the position information on behalf of clients while also facilitating trading, providing pricing information, and managing cash activity.

3 The key responsibilities of a custodian bank are to: Hold assets in custody. This occurs onshore, offshore with an affiliate, or offshore with a sub- custodian . When needed, the main custodian is responsible for selecting the sub- custodian . Provide daily and/or monthly asset pricing. Pricing information is provided to custodians by third-party vendors that are reviewed for accuracy and methodology. Monitor and settle depository transactions. Custodians are also critical in monitoring and settling trades. They are connected electronically to the depositories, providing Operational efficiencies and economies of scale when initiating and settling trades. Monitor and post income payments. Custodians track and record interest on bonds and equity security dividends. The custody system monitors the scheduled payment date and ensures the correct payment is posted to the right account. Provide audited reporting.

4 The custodian provides final market value, transactions, cash positions, and cash activity on a daily or monthly basis. Other services that custodian banks often provide include proxy voting, tax reclaim services, corporate actions, cash management, performance reporting, risk reporting, compliance monitoring, securities lending, and foreign exchange. Aon Hewitt Retirement and Investment Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. Operational Risks and your custodian : A Perfect Match? 2 The largest, most sophisticated and capable global custodian banks bring many advantages when they provide Operational services. The economies of scale they are afforded by servicing trillions of dollars in assets keeps costs low and service levels high. Their dedication to the custody business is evidenced by investments in personnel and technology, and also is driven by the percentage and level of revenue the custody business provides to the overall bank organization.

5 They benefit from the global network ( , sub- custodian network, depositories) they have developed over many years of servicing global clients. Because institutional investors rely heavily on their custodian banks to provide Operational support, custodian banks should be evaluated based on their ability to mitigate the investor s key Operational Risks . Here, we provide a framework for performing this evaluation. Operational Risks : Finding Their Perfect Match We identify 12 key Operational Risks that are faced by institutional investors and offer guidance on the processes, capabilities, and expertise a custodian must possess to help mitigate them ( , what makes a custodian the Perfect match ). Not every investment program will be exposed to every one of these Operational Risks , but a significant portion will apply to all institutional investment programs. 1. Headline Risk Definition This is the risk that the custodian experiences a high-profile negative event that spreads throughout the media and negatively impacts the institution s credibility.

6 Headline risk is important to consider because a significant organizational issue at a custodian can cause undue concern and scrutiny, and force change. Organizational stability is also important because of the exposure institutional investment programs have to the custodian bank. Should there be any significant issues, there could be risk to the safety of the assets, the ability to process transactions, and other Operational complexities. Evaluation Criteria Evaluating and monitoring a custodian s financial and organizational stability is paramount in mitigating headline risk. Key factors include capital ratios, credit ratings, total assets under custody, revenue generated by custody operations, and the SSAE16 report. In recent years, the number of lawsuits filed against custodian banks or their parent organizations has increased; therefore, institutional investors should be aware of the level and breadth of any legal issues faced by the custodian banks.

7 2. Contract Risk Definition Contract risk is the risk that something material is missing from the custody contract or that key Operational topics have not been clearly or completely described. Lack of clarity in key areas presents significant risk. Evaluation Criteria Investors should conduct a comprehensive evaluation of the custody contract on a periodic basis (typically every three to five years) and if possible, compare the current document to other custodian contracts. There are a number of key Operational factors to evaluate within the custodial agreement to Aon Hewitt Retirement and Investment Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. Operational Risks and your custodian : A Perfect Match? 3 ensure they have been clearly defined, including the roles and responsibilities of the custodian and client, the description of services provided by the custodian , and the level or existence of indemnification should the custodian make a mistake.

8 In addition, legal counsel should be intimately involved in the negotiation process to ensure that the contract suitably protects the client from losses due to negligence, fraud, and willful misconduct. 3. Regulatory Risk Definition Regulatory risk is the risk that a custodian bank is adversely affected by or is out of compliance with a regulation, likely resulting from a lack of preparedness. The regulatory environment is extremely fluid and custodian banks must stay abreast of changes. Evaluation Criteria We expect a custodian bank to have a group dedicated to regulatory affairs. While it is not necessary that this group reside within the custody division, we do expect that the custody division participate in regulatory oversight efforts. Changes to regulations can impact the viability of business lines or products. Utilizing a team of individuals to analyze regulatory implications on the firm s overall business strategy and to participate in industry trade groups is something we view favorably.

9 4. System Integration Risk Definition System integration risk relates to the integration of systems, and is the risk that the conversion of raw custody data to accounting reports is not completed in an accurate, timely, and automated fashion. System integration risk also covers the risk that the accounting data does not accurately and seamlessly flow through to other platforms such as performance reporting, compliance monitoring, and private asset administration. Additionally, there is the risk that the underlying feeds providing inputs to client-ready reports are of insufficient quality. Evaluation Criteria System integration risk can be evaluated by understanding the systems and processes the custodian has in place to flow data through the various custody platforms, how the systems are built and maintained, the frequency of data transmission, how much manual intervention is involved, and the reconciliations that are performed.

10 5. Trading Risk Definition custodian banks process millions of trades every day and are ultimately responsible for ensuring that trades are processed correctly (meaning cash and securities get to the right place at the right time). Trading risk is simply the risk that a trade is not settled or processed appropriately and causes losses or liquidity issues within the investment program. Evaluation Criteria Sound procedures for processing and settlement help ensure that trades will not fail. Such procedures should be refined over time as markets develop and innovations occur. When possible, we expect a custodian to be a direct participant in a given market, and to have an automated process Aon Hewitt Retirement and Investment Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. Operational Risks and your custodian : A Perfect Match?